Overview

This Chapter provides an overview of short and long hedges and discusses their appropriate uses in risk management. Hedging is a financial strategy used to mitigate potential losses from adverse price movements in assets or commodities. By understanding the differences between short and long hedges, businesses and investors can make informed decisions to protect themselves from price volatility and uncertainty.

Definition of Short Hedge

A short hedge is a risk management technique used to protect against the decline in the value of an asset or commodity. It involves taking a short position in a futures contract, which serves as a hedge against a corresponding long position in the physical asset. Short hedging is commonly used by producers, such as farmers and manufacturers, to secure a minimum selling price for their products.

Example: A wheat farmer who expects to harvest a crop in three months may worry that the price of wheat will decrease by the time of the harvest. To protect against this price decline, the farmer can enter into a short hedge by selling wheat futures contracts for the quantity equivalent to the expected harvest.

Definition of Long Hedge

A long hedge is a risk management strategy used to safeguard against the increase in the price of an asset or commodity. In a long hedge, an investor takes a long position in a futures contract to offset the risk of owning the underlying asset, which may experience price volatility. Long hedging is often employed by consumers, such as manufacturers, to secure a maximum purchase price for essential raw materials.

Example: An airline company may be concerned about the rising fuel prices in the future, which could adversely impact their operating costs. To mitigate this risk, the airline can enter into a long hedge by purchasing jet fuel futures contracts, thus fixing the cost of fuel for the desired period.

Differences between Short and Long Hedges

Short and long hedges differ in their objectives and application. The primary distinction lies in their response to price movements. Short hedges protect against price declines and benefit from falling prices, while long hedges safeguard against price increases and benefit from rising prices. The decision to use a short or long hedge depends on the risk exposure and desired outcome of the hedger.

Example: A jewelry manufacturer may face price volatility in gold, which could lead to either higher production costs (long hedge) or lower revenue from gold jewelry sales (short hedge). The choice of hedge will depend on the company’s assessment of future gold price movements and its specific risk exposure.

Appropriate Uses of Short and Long Hedges

Short and long hedges are appropriate in various scenarios based on the hedger’s position and risk exposure. Businesses in commodity-related industries, such as agriculture, energy, and manufacturing, often use short and long hedges to manage price risk in their supply chain and ensure profitability.

Example: An oil exploration company may implement a long hedge to protect future revenues from oil sales, while a gasoline retailer could employ a short hedge to mitigate the risk of price declines in gasoline inventories.